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Deal on dividend tax is small victory for investors

Spending cuts, debt ceiling battles to drive volatility

The biggest winners from stage one of Washington's fiscal cliff agreement might be investors in general and dividend stock investors in particular.

Beyond that, the deal adds up to a tax hike for almost everyone and in-creased market volatility as lawmakers approach a deadline on spending cuts just two months hence.

“The agreement on dividend taxes was the biggest surprise because it was seen as almost a foregone conclusion that dividend tax rates would be set at ordinary income tax rates,” said John Buckingham, chief investment officer at Al Frank Asset Management Inc. “A lot of folks thought the negotiations in Washington were going to be the kiss of death for dividends, and that's why we saw a lot of companies accelerate their dividend payouts before the end of the year.”

NEW RATE

According to the terms of last week's budget deal, households earning more than $450,000 a year, or $400,000 for a single person, will be taxed on dividends and capital gains at a 23.8% rate, up from the previous 15% rate.

The new rate, which includes a 3.8% tax on investment income to help pay for the federal health care law, is considered a bonus compared with the new top ordinary income tax rate of 39.6%, up from 35% last year.

The health care law tax kicks in for households making $250,000, or $200,000 for singles, adding up to an 18.8% tax on dividends and capital gains at those income levels.

“This means that dividends are no longer off the table as investments, especially in those investments where your dividend payouts are growing year after year,” said Joseph Witthohn, vice president of product development and exchange-traded-fund strategies at Emerald Asset Management Inc.

Even as most market watchers criticized the fiscal cliff deal as being overly dramatic and underproductive, they touted the dividend tax rate as a small victory for investors.

“The whole thing is just a stopgap measure or a temporary Band-Aid, but it should allow for more risk-on investing for the time being,” said Quincy Krosby, a market strategist at Prudential Financial Inc.

“But as far as the taxes on dividends and capital gains, that was the best-case scenario,” she said. “That should help keep investors in the dividend-paying stocks.”

On the first trading day after the tax package was passed by the House of Representatives last week, the Dow Jones Industrial Average gained more than 300 points for its biggest one-day jump since December 2011. But market watchers and analysts warned against making too much of the rally.

“The market reacted positively because everybody knows it could have been much worse,” said George Feiger, chief executive at Contango Capital Advisors Inc.

Mr. Feiger, who remains bullish on U.S. equities and the strength of the U.S. economy, thinks that financial markets are growing in spite of Washington.

“You have some sort of agreement on marginal personal income taxes, but the issue is that the federal fiscal structure remains unsustainable,” he said. “And that ridiculous overnight cram session by Congress has done nothing to address the fundamental problems.”

"EUROPEAN-LIKE'

Citing the deadlines on the federal government's debt ceiling and other spending cuts that were postponed for two months, Mr. Feiger said: “This is a very European-like action to kick the can down the road when the arithmetic doesn't add up.”

With the new tax rates on dividends and capital gains, Congress “created a situation where people who can in any way get paid in equity are going to be subsidized by people who earn a paycheck,” Mr. Feiger said.

In terms of industry sectors, it might take a few months to gauge the full impact of the higher taxes.

Paul Schatz, president of Heritage Capital LLC, expects the higher tax rates to result in a direct hit on consumer discretionary stocks.

“People who got hurt the most with this deal are people who make the most, so I'm looking for leisure and consumer discretionary stocks to underperform,” he said, adding that 75% of discretionary spending comes from households earning more than $250,000.

WATCHING WAL-MART

Ms. Krosby has a slightly different take, suggesting that people at lower income levels will experience the biggest hit with the 2-percentage-point jump in the payroll tax.

In 2011 and 2012, employees' payroll tax, which is used to fund Social Security, was cut to 4.2%, from 6.2%. It has gone back to 6.2%.

“The payroll tax holiday was introduced in order to foster consumer spending,” Ms. Krosby said. “The tax hike across the board could crimp spending for lower- and middle-income earners, so we'll be watching companies like Wal-Mart [Stores Inc.] as an indicator.”

One wild card is the municipal bond market, which some think could still be on the chopping block for the next round of negotiations.

“They're going to need to find additional funds somewhere, and I think the tax-exempt status of munis will be back on the table for the debt ceiling negotiations,” said Jennifer Vail, head of fixed-income research at U.S. Bank Wealth Management.

In the meantime, however, there is reason to believe the higher tax rates could make muni bonds even more attractive to some investors.

“This could all cause some increased volatility in the muni market,” Ms. Vail said. “There absolutely is another battle coming, because we've only dealt with the tax side.”